Learn to hedge like a Wall Street trader

World’s most famous traders like Warren Buffet use hedging strategies in trading. Discover the concepts behind hedging strategies and learn to hedge like a Wall Street trader.

Another Forex hero that we are going to talk about had actually successfully managed money for George Soros for several years. Stanley Druckenmiller began his financial career in 1977 as a management trainee at a Pittsburgh bank. He became famous when he was featured in the best-selling book, The New Market Wizards.

In 2008, the financial markets had their biggest decline since the financial depression of 1929. The sharp decline led to the shut down of many hedge funds who were long the stock markets in developed nations.

Warren Buffett's firm declined by more than 32%, which was the worst performance in more than 30 years. This is because Warren’s strategy is to invest in undervalued companies. On the other hand, James Simmons who runs a hedge fund called Renaissance Technologies had a great year after his fund rose by more than 40%.

The difference between the two funds is that Warren Buffet uses few hedging strategies. Simon’s firm, on the other hand, is built on the foundation of hedging, a strategy that helps him make money even in choppy markets. Indeed, in the past 30 years, Simon’s firm has generated annual returns of about 40% while Buffett's firm has had annual returns of about 20%.

The idea behind hedging is simple. In times of a downturn or a financial crisis, stocks tend to move lower all together regardless of their quality or industry. This exposes long-only investors to the risk of losing money in case a bullish market reverses.

The concept of correlation

Another basis for the hedging strategy is that no form of analysis is ever perfect. A trader’s trading system can show a bullish signal only for the chart to move lower. In addition, a trader can predict accurately the economic data to be released only for the assets to move in the opposite direction.

To understand how to hedge, the concept of correlation is very important. Correlation is simply the mutual relationship that exists between two financial assets. For example, some assets are closely correlated which means that their prices tend to move in the same direction. A good example of this is the Brent and WTI futures. In the first half of 2018, the two gained 6.5% and 8.0% respectively. In the previous 12 months to that, the two gained 31.6% and 31.9% respectively, while in the previous five years, the two had fallen by 34% and 37% respectively. These numbers show how closely correlated the two crude oil benchmarks are.

On the other hand, some financial assets are negatively correlated. This means that when one asset moves up, the other one tends to move lower. A good example of two negatively correlated assets are gold and the US dollar. The reason for the correlation is that gold futures and physical gold are usually traded in USD terms. Therefore, when the value of the dollar rises, it tends to affect that of gold. Another reason is interest rates. As a metal, gold has no return like dividends. Therefore, in periods of rising interest rates, traders prefer owning the yielding dollar rather than nothing-yielding gold. Another reason is that gold is viewed as a safe haven asset. Therefore, in periods of increasing risks, traders tend to move to gold, which raises its value.

Positive and negative correlations can be seen in many places. For example, the decline in the prices of gold and other precious metals will mean lower profits and margins for miners, leading their stock prices to fall. In 2018, the 6% decline of gold led to a 20% decline in the stock of Barrick Gold, which is one of the biggest gold miners in the world. The same relationship is true for crude oil and agricultural commodities and their respective companies.

The same concept of correlation is true for currency pairs. Some currency pairs tend to move in the same direction while others tend to move in the opposite direction.

How to hedge

The first step a trader needs to do when using the hedging strategy is to find the correlations between financial assets. There are two main ways to do this. First, a trader can use the freely available online resources to calculate the correlations. Alternatively, a trader can calculate the correlations from scratch. A simple way to do this is to take the closing prices of the two assets, enter them into Microsoft Excel or Google Sheets, and then use the Correlation formula. A result of 1 means that the two assets are perfectly correlated while a result of zero shows no correlation. A minus 1 correlation shows a negative linear relationship.

After calculating the correlations between the assets, the trader should conduct analysis to find the likely direction of an asset. This analysis should include a technical analysis which uses indicators like Moving Averages and Bollinger Bands. It should also include fundamental analysis, which means following economic data releases.

If you find that an asset is likely to move upwards within a certain period, you would place a buy trade. Then, using the correlation data, you could enter a smaller countertrade. For example, in the case of Brent and WTI, if you find them closely correlated, you can buy one lot of Brent and sell short one lot of WTI. If the price moves as planned, the Brent trade will make a profit as the WTI trade makes a loss. In this example, the trader’s profit will be the difference between the two.

Another common hedging strategy is where a trader buys and sells one asset at the same time. For example, if an asset is trading at $10, a trader can buy 1,000 units of the asset and simultaneously sell short 800 units of the asset. If the asset moves up, the trader’s profit will be the difference or spread between the profit and loss. If the asset moves down, the trader’s loss for the buy trade will be mitigated by the opposite trade.

The risk

When hedging is done well, it can help caution a trader from major losses. However, hedging does not always work. A good example is what happened to the famed hedge fund manager David Einhorn. In his portfolio, he made long investments in General Motors while placing shorts on Tesla. At the time of writing this article, General Motors has fallen by 9% while Tesla has risen by 15%. His other short investments like Netflix and Amazon have all rallied by more than 72% and 58% respectively while the long investments have fallen as well. This led to his firm to record huge losses.

To limit these losses, a trader needs to use take profit and stop losses effectively. A stop loss will close a trade when it reaches a specific losing level while a take profit will close the trade when a certain profit level is reached.

Bottom Line

Hedging is one of the best ways traders can make money while reducing the risk they are exposing themselves to. This concept is the foundation of the hedge fund industry. To succeed, you need to understand the concept of correlations, the different varieties of hedging strategies, and how to size the two trades.